A' Limited has issued 2,000 equity shares of Rs. 100 each as fully paid. The company has earned a profit of Rs. 20,000 after tax. The market price of these shares is Rs. 160 per share. On these share dividend has been paid @ Rs. 8 per share. Find out the cost of equity capital using Earning Yield method :

Question

Accepted Answer

The correct option is 1: 0.0625

The Cost of Equity ($K_e$) using the Earning Yield Method, also known as the Earnings Price Ratio Method, is a technique that estimates the cost of capital by relating the total earnings available to equity shareholders to the current market value of the share. This method operates on the principle that the company's market price reflects the capitalised value of its expected future earnings, and therefore, the earnings yield serves as the required rate of return for investors. The formula for this method is $K_e = \frac{	ext{Earnings Per Share (EPS)}}{	ext{Market Price per Share}}$. First, we must calculate the Earnings Per Share: $	ext{EPS} = \frac{	ext{Total Profit After Tax}}{	ext{Number of Equity Shares}} = \frac{	ext{Rs. 20,000}}{	ext{2,000 shares}} = 	ext{Rs. 10 per share}$. Plugging this into the formula gives us $K_e = \frac{	ext{Rs. 10}}{	ext{Rs. 160}} = 0.0625$. The dividend paid (Rs. 8 per share) is extraneous information for the Earning Yield method.

The incorrect option is 2: 0.0525
This option is incorrect as it does not result from the proper application of the Earning Yield method using the figures provided. The required numerator for this calculation is the Earnings Per Share (Rs. 10), and the market price is Rs. 160. To arrive at 0.0525, the EPS would have had to be Rs. 8.40 ($\text{Rs. 8.40} / \text{Rs. 160} = 0.0525$), which contradicts the calculated EPS of Rs. 10. This result likely stems from a calculation error or the incorporation of an unfounded adjustment to the correct variables.

The incorrect option is 3: 0.05
This option represents the Dividend Yield, which is a different method for calculating the cost of equity. The Dividend Yield method calculates $K\_e = \frac{\text{Dividend Per Share} (D)}{\text{Market Price per Share} (P\_0)}$. In this case, $\text{Rs. 8} / \text{Rs. 160} = 0.05$. Although the necessary data is provided, the question explicitly demands the use of the *Earning Yield* method. The Earning Yield method is generally considered more comprehensive because it accounts for all earnings generated for shareholders, whether distributed as dividends or retained for future growth.

The incorrect option is 4: 0.07
The value 0.07 or 7% is mathematically incorrect when applying the standard Earning Yield formula to the problem's data. For $K\_e$ to be 0.07, the Earnings Per Share would have needed to be Rs. 11.20 ($\text{Rs. 11.20} / \text{Rs. 160} = 0.07$). Since the total profit after tax is a fixed Rs. 20,000 and the share count is 2,000, the EPS is definitively Rs. 10. Therefore, this option is a plausible distracter based on an unsupported earnings figure.